Credibility and disinflation in the European monetary system

Abstract

Analysis of interest differentials in the European Monetary System has suggested a widespread lack of credibility of the Exchange Rate Mechanism in the sense that in most countries the implicit expected rate of devaluation was significant and not far short of inflation differentials vis-à-vis the deutschmark. We present and test a model in which prices reflect expectations of exchange rate behaviour. The results provide mixed evidence that price-setting in countries which participated in the ERM was influenced by the exchange rate discipline.